As has been the case so many times, the details of this debacle are found in the regulatory changes lobbied for — and recieved — by Corzine and the MF Global legal crew. In researching this column, I discovered several deeply disturbing facts.

Here’s an excerpt from the column:

1. What MF Global did with client monies was “technically” legal (though it probably violated the spirit of the law).

2. Britain’s leverage loopholes provided a back door for U.S. firms such as Lehman Brothers and MF Global to “re-hypothecate” client assets — and leverage up.

3. As a result of MF Global’s lobbying, key rules were deregulated. This allowed the firm to use client money to buy risky sovereign debt.

4. In 2010, someone from the Commodities Futures Trading Commission recognized these prior deregulations had dramatically ramped clients’ exposure to risk and proposed changing those rules. Jon Corzine, MF Global’s chief executive, successfully prevented the tightening of these regulations. Had the regulations been tightened, it would have prevented the kind of bets that lost MF Global’s segregated client monies.

5. None of MF Global’s Canadian clients lost any money thanks to tighter regulations there.

6. Little noticed in this affair is (once again) the gross incompetency of the ratings agencies. Had they not been maintaining “A” ratings on Spain and Italy, MF Global could not have made its disastrous bets there.

The dead tree version of the paper uses a photo of Corzine that is not particularly flattering:

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

54 Responses to “MF Global Collapse Reveals Systemic Risk”

As a regular middle aged middle class American with an IRA, 401(k), and a checking account, I am stuggling to care about the clients of MF Global. I suppose its possible that one of the mutual funds in my meager portfolio used MF Global, but I would never know.

It angers me that the only reasonable way for me to save for retirement is to participate in these schemes, but aside from the employer match and tax deferral, I might as well have left the money in my mattress. Somehow I think the clients of MF Global are getting exactly what they deserve. Maybe we need a few more spectactular collapses to teach us all the lesson that these companies are not investing or even speculating. They aren’t providing needed liquidity. They are gambling and the game is rigged against the client. So I don’t think it is fair to blame the regulators or ratings agencies, they are simply in on the scam.

“Before reaching the casino floor, slots are subjected to lengthy compliance tests in order to be approved by regulators. Those tests make sure the games are fair and reliable.”

Yeah, the gaming industry has regulators too making sure “the games are fair and reliable”, but the House still always wins.

~~~

BR: Struggling to care?

When you wake up one day, and your 401K, IRA and investment accounts have been emptied, let me know if you still are struggling . . .

‘The shadow banking system — the alternative system existing outside of the regulatory rules — is highly dependent on derivatives and leverage. In particular, it is highly dependent on the sort of accounting and credit games like the re-hypothecation and off-balance sheet repos that led to MF Global’s demise. Its failure revealed an enormous degree of systemic risk that remains in the current banking system.’

The problem of course is that this shadow model is the source of much revenue by the financial parasites.
It’s sole existence is to enrich the banksters. It has little if any economic value to the real economy.

So who were receptive to the lobbying efforts of MF Global? Who were not receptive? Did they receive campaign contributions? Did any personal relationships with Corzine or others at MF Global play a role? Any evidence that those who were receptive actually understood the issue? Did MF Global’s competitors behave the same way?

For actual change to happen, if at all possible, somebody needs to call out the actual responsible Congress members, in this case and in many others, not just the usual “lobbied for and received” line.

I do think MF broke the rules, in spirit if not in fact however I pose the following to both you , other readers and myself.

Do we know this the result of rule 1.25 & rehypothecation?
1)Jill Sommers said the rule, regulation 1.25, does not apply to the investments MF Global may have made because the CFTC does not regulate the broker dealer side of MF Global.
2) CME stated that the customer money was moved after it’s audit end October

It has been repeatedly demonstrated and at this time the expectation is not there for the rating agencies to sound an early warning bell, you had a great quote recently that the rating agencies can be expected to show up after the battle only to shoot the wounded. The regulators look at debt prices and CDS levels, as do traders.

While the rehypothecation discussion may have been an important contributor and perhaps we’ll learn that client money was taken during a margin call by a JP Morgan or similar, this could just boil down to something simpler, a willful or negligent behavior to properly segregate customer funds and perhaps the intentional use of those funds.

With regards to regulators we see that no one regulator can see the entire picture(AIG again). We saw that the CFTC who congress under funds and is prohibited from self-funding has to rely on self-reporting by the firms they over-see.

It seems that the awful reality we are left to deal with stems from our actually maintaining a crony capitalism system rather than a free market capitalism. If someone couldn’t secure special favors promptly in closet somewhere in the dead of night, it would appear that we would many fewer of these difficulties. While we strive for transparency in our legislation and business activities, perhaps we should incorporate specific requirements forcing transparency and slowing the special pleading process down. For starters, maybe we should start to incorporate those super-majority voting provisions in the financial services legislation like so many want to include in tax legislation. Needing to obtain (I dare not use the word ‘procure”) a two-thirds vote for some of this stuff just might prevent some of the really odious provisions from getting through.

Really nice article.
Recently, as I crawled through a local school zone at 15 mph, I was struck by the following analogy. These kinds of maneuvres by MF Global are akin to trucking firms going to the city council and saying, “Nobody ever exceeds 15 mph going through that school zone so we are suggesting that you do away with the speed limit entirely. It is unnecessary regulation.”
There seems to be a disconnect between recognizing that a regulation is effective and should be retained at its current level of control and recognizing that a regulation is obsolute and unnecessary. Perhaps it is a product of the system being sold out or it is more a product of the legislators, regulators and perhaps the industry itself not anticipating where relaxing that regulation would ultimately lead. Perhaps they only want to go 18 mph through that school zone but, awhile later, of course everyone is going 40 mph.
I think the housing crisis is a perfect case of that – in many ways.

I have to agree that it is highly unlikely there will ever be anything remotely beyond a wrist slap when it comes to the corporate, governmental, and regulatory malfeasance/incompetence of the past . The statute of limitations is ticking on any prosecutions under Sarbanes-Oxley and some have already absconded from justice as such. See Taibbi’s article from Feb 2011.

They will simply run out the clock since they’re in a winning position. These side shows are just a setback that actually help to keep the focus on minor scuffles rather than a larger conflict that are as the article suggests: systemic. This is the final minute of play in the third period.

Derivatives and leverage, indeed financial “products” of any kind , are at the heart of our troubles — their sole reason for being brought into existence being to create the illusion of value where there is none, and, in the process, to extract by fraud as much “investment” (real) capital as possible for those allowed to create, lever, and sell such products. This is clearly a racket. Our entire system has been undermined by fraud, and everybody is everybody else’s counterparty.

I began to suspect some weeks ago that the loss of MF Global’s customer money may well have been legal, and began researching what steps a brokerage client should take to protect themselves.

First and foremost, don’t keep your money at firms known to be highly levered, known to have UK branches, and known to have prime brokerage business. Second, revoke all margin agreements you might have. Better yet, open a cash account, transfer all positions into it, and close your margin account. That way, your broker does not have your signed margin agreement on file for any account containing assets. If you must have a margin account, keep all free cash balances and non margin securities out of it.

It’s not easy these days to get securities taken out of book entry or street name and have the physical certificates delivered to you, but I’ve been looking into that. US Treasuries can be purchased through Treasury Direct, and those that have already been purchased in your brokerage account can be reregistered to Treasury Direct

Help!!! What is the ordinary investor to do? Where is it safe to invest? In a stock brokerage account? Only within SIPC limits? Within secondary insurance (eg-LLoyd’s of London) limits? Is direct registration recommended? Should I take possession of my stock certificates? Or do I just go off the grid with a gun and gold coins in a cave in Montana? Help!!!

Golem XIV has an interesting theory about re-hypothecation and bankruptcy laws

“under a 2005 amendment to the bankruptcy laws, derivatives counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy”

Great article, but I was confused by the pronoun reference. Who is the ‘you’ who still owns the stock? — the client using leverage, the broker making his own trades using the clients stock as collateral, or some other ‘third party’ broker? I’m not familiar with how this works. It seems different from what MF Global was doing, basically using clients cash money to trade on MF Global’s account, as I understand it.

To equity traders, hypothecation occurs when their broker uses client stock holdings as collateral for trading or leverage. To oversimplify, buying equity with leverage involves pledging shares (collateral) to a third party (broker) in order to borrow against them. You still own the stock, but the broker can sell it if you fail to make payments when necessary. (This is the basis of a margin call and forced liquidation.)

What was that line in The Magnificent Seven? Something like — “If God didn’t want them to be shorn He wouldn’t have made them sheep”……turning money over to others, any0ne, and allowing their judgment to control where it goes is a very flawed strategy, especially given that all of us who read even one Madoff story are on notice that this stuff happens.

The GOP continues to fight any regulation on the debt these financial house can take.

They say there is “too much,” yet there isn’t enough to stop this, but MF Global still took on too much gearing.

They say the French, the Europeans have too much regulation, but the French banks are all over-leveraged.

They say regulations “don’t do any good” but Canadian and Swedish banks with the right kind of regulations aren’t part of the problem.

They continue to fight Dodd-Frank, refuse to allow Obama” nominee to head the consumer financial protection office, and claim that business is stifled by “all these regulations”

We need the right rules, not the GOP gutting, watering down and compromising on them resulting in their
weakening. …the GOP who can’t even agree to pass a tax cut. That’s the GOP you love. Well YOU are the problem, GOP genuflector.

You cannot arrest someone just because they look unflattering in a recent photo. However, if they lose, vaporize and otherwise destroy $12 billion they deserve a flattering mugshot… taken from their new prison cell by a Canadian photographer who disdains rating agencies.

Given how easy it is in general to move money, with online wire transfers (from at least some brokerages) to either banks or in a number of case brokerages that sweep cash to money market funds, I wonder why the folks at MF global did not insist on that. Unless that is MF Global did not have the transfer option.

Of course the main issue is that almost no one trades in commodities futures on a cash basis, its all margin. Recall how when they increased the margin on Gold as it ran up the priced crashed for a couple of days as some positions had to be liquidated, due to the increased margins. Commodities are still a wild west of wall street, with the sheriff sleeping in the jail, and in addition being a poor shot compared to the bad guys. Now if instead of futures options were traded, then the money involved would be a lot less, since the value is the difference between the cash price and the option price plus or minus the effect of future events.

Barry – per your article – why is European debt “junk” and US debt “safe”? The only difference is that in Europe, the ECB will loan unlimited money to banks to buy soverign debt, and in the US, the Federal Reserve bank buys it directly from the government. Both seem pretty risky to me.

~~~

BR: That your lens.

For US clients, the rule was always US treasuries were AAA and safe for sweeps and ST purchase.

The USD is the worlds reserve currency. Oil, grains, ores… all of the hard and soft commodities are priced in US dollars. The Federal Reserve gets the float on the majority of global commodities transactions.

To my simple way of thinking, the ‘full faith and credit’ of the Federal Reserve Note is backed up by the worlds largest military.

It took two world wars for the USD to take over from the British Pound Sterling as the global currency.

All the points are good, but the fact that what happened at MF Global may have been *technically ‘legal’* is the kicker.

How many people are going to figure out that it is now ‘legal’ for the bank to steal your bars of gold, silver, and the cash in your account? And as people start to figure out that may be ‘legal’, what will be the reverberations?

I think a lot of mattresses are going to be lumpy, with all the stuff getting stuck under them over the short term.

What algernon32 said plus, the ECB program to support bank purchases of sovereign debt kicked into high gear after MF Global got the big margin call.

It’s rather restrictive in a number of respects and basically bypasses each EU country’s central bank while supplying capital for banks in that country under conditions that maximize their profit if they acquire their own country’s debt.

This isn’t just about price stabilization, although it is certainly that too, it looks like it is about preparing for some countries to repatriate and consolidate their own debt in preparation to either endure austerity in discharging it or leave the Euro.

Investors are furious that they can’t get back the gold and silver they stashed with the failed brokerage.

It’s one thing for $1.2 billion to vanish into thin air through a series of complex trades, the well-publicized phenomenon at bankrupt MF Global. It’s something else for a bar of silver stashed in a vault to instantly shrink in size by more than 25%. That, in essence, is what’s happening to investors whose bars of silver and gold were held through accounts with MF Global.

The trustee overseeing the liquidation of the failed brokerage has proposed dumping all remaining customer assets—gold, silver, cash, options, futures and commodities—into a single pool that would pay customers only 72% of the value of their holdings. In other words, while traders already may have paid the full price for delivery of specific bars of gold or silver—and hold “warehouse receipts” to prove it—they’ll have to forfeit 28% of the value.

That has investors fuming. “Warehouse receipts, like gold bars, are our property, 100%,” contends John Roe, a partner in BTR Trading, a Chicago futures-trading firm. He personally lost several hundred thousand dollars in investments via MF Global; his clients lost even more. “We are a unique class, and instead, the trustee is doing a radical redistribution of property,” he says. Roe and others point out that, unlike other MF Global customers, who held paper assets, those with warehouse receipts have claims on assets that still exist and can be readily identified.

John Corzine – we know that there are no laws to prosecute him – so I guess he should hire some bodyguards – he buried lots of Republicans who own guns – goodbye john

someone who spent his whole life building his reputation and what will he be remembered as/for.

People who have assets to protect…better learn how to manage their own assets – some of the “smartest” (sic?) people in the world have been duped – and they deserve to be taken. Money is a Job in itself… don’t let anyone run your cash register.

Just read the fine print in your account papers for margin accounts, or any brokerage account for that matter. It is legal because the regulations allow it, and the account holders give permission to the brokers when they sign on the dotted line.

How much of the stuff that caused the real estate crash was legal? Most of it, which is why they cannot prosecute the banks, except in the case of out right fraud.

1) Bogus accounting is a scandal – the fact that a giant prop bet was off-balance sheet. MF Global was still 100% on the hook for massive credit risk and margin calls, they booked the P&L presumably up front, and it didn’t show up on the balance sheet until they got smacked by FINRA. The self-regulator of all people – has to be pretty egregious for the self-regulator to step in. Supposedly after Enron this crap was supposed to stop. But same happened with Citibank and the ‘liquidity put’ SIVs, and it’s STILL going on?

2) the absence of umbrella SIPC type protection for futures accounts is, if not a scandal, a major gap. You have money at Interactive Brokers. They say they sweep cash into the SIPC-protected securities account. So in theory, the clearinghouse backs up the futures contracts, and the SIPC backs up the cash and equities. But customer losses were incurred with Refco, now MF Global, so one can’t help thinking that pledge has no value.

3) There was actual fraud. The idea that this was all according to the letter of the law doesn’t seem credible. The money went somewhere – the customer shortage plus the bank’s capital cushion. It seems too big a loss to be just the sovereign debt. Either they lost the money fair and square and cooked the books until they couldn’t (like Refco), or someone stole it (embezzlement, fraudulent seizure of excess collateral to sell cheap to related parties, etc.). Money went out of segregated accounts, and it’s not supposed to, and I don’t think all the farmers signed agreements allowing it.

The way this is being framed sucks (no fault to you, BR). JPM, as the segregated account holder, should be responsible. That is the entire point of having someone else, beside the broker, hold the money.

This is a matter for the OCC and the FBI, they should have been inside JPM with handcuffs 2 months ago. Having the CFTC look into it is a complete joke.

MF Global CEO’s “chaos of paper” has a Timeline that will make perfect sense to the FBI and CME on the theory that no one writes big checks at random. Elliot Ness will get the accountant, and Chicago CME wins best practices. There’s still as place where if it trades through your price, you’re done. NY was always a fast market; they earned it!

Neildsmith took a couple bodyslams (since I’m signed in) maybe the blogger doesn’t understand fully the segregated accounts aspect … farmers & ranchers who need (in the current system) to hedge their products because of bad weather or market layer aspects between the supplier & wholesaler need a facility like MFG .. and the $250K FDIC guarantee at banks is probably short for their operations.

Write your congressmen today – if there is public outcry the indictments wills stack up like Income Tax Regulations.

Interestingly, the liberal policy advocates aren’t crying for prosecution – they are blaming the 1%, without asking for prosecutions. It reminds me of when Obama said he’d reduce the cost of health care by 25% and the crowds cheered, then when Obamacare came out without any spending cuts, the crowds were silent . Now health care is up 9% 2 years in a row – no complaints. Dems and republican omit the 27% medicare cut again – silence.

There a huge gaps between what the liberal policy advocates cheer for and what they do. They want health care costs cut, but don’t demand the gov’t cut spending. They want the heads of the 1% but they don’t want prosecutions.

This is a wonderful post and accessible to the general public. But it is lacking in one respect-it leaves the reader with a big unanswered question which I think you should address. What is the ordinary investor to do? Is their stock brokerage account safe? IMHO you should tell the readers to stay within SIPC limits and that secondary insurance (eg-Lloyd’s of London) limits may not help in a real crisis. They should use direct registration or take possession of their stock certificates if their accounts are above SIPC limits.

Corzine and MF Global is a major event in the financial sector, much bigger than Madoff. Madoff just ran aPonzi scheme, confessed, and is in jail. Money that has been found is being redistributed to clients.

MF Global strikes at the fundamental heart of the financial sector. There can’t be a financial sector if nobody trusts them to hold money overnight. One of the major revolutions in the 1930s was a moderately low level of depsoit insurance at banks and regulations limiting MF Global types of activities with invested funds that effectively allowed for the rise of mutual funds over the ensuing decades.

The financial sector used to take excess money subtly. They simply overcharged an extra coupleo f percent per year of your asset base. They left you with visible gains, just not as much as you could have had if you were a big fish. Corzine is changing that paradigm by showing financial firms can simply take your money without having a long-term sustainable relationship with their victims.

Lyle – my understanding is that some clients did ask for and get wire transfers of money. Apparently, in at least one case, the wire transfer was pulled back after it was initially deposited into the client’s bank, presumably at the behest of one of the collateral holders.

I believe that eventually there will be at least SarbOx crimes out of this. People moving hundreds of millions of dollars around leave paper trails with names attached to the transfers. If people inside the organization were able to “lose” a billion dollars with no good paper or electronic trail and no authorizations from senior management, then there will probably be a massive fail on the “adequate financial controls” requirements of SarbOx. On the projects I work on, authorizations for $10 million dollars plus have to go to the CEOs and CFOs of Fortune 500 companies for their approval, even though it is generally pro forma. I can’t imagine some trader at MF Global was deciding to move $500 million of cash to JPM on a whim with no oversight.

Sorry if this question has been asked and answered.
Did the clients of MF Global know that this could happen? It certainly changes the conversation if they were informed of the risk. I have a feeling that they weren’t.
In any case, this practice should be illegal. The clients were essentially taking all the risk with no chance for reward.

My understanding is that many of the farmers, ranchers etc. dealt with a broker who used MF Global as a clearing house. The end clients probably never saw the MF Global account agreement (we typically don’t see the one that our mutual fund has with the custodial account holder, e.g. State Street, for our internal mutual fund holdings). The broker probably did not focus on the fine print, because this fine print item was probably something they probably had little experience or expertise in.

That actually raises another potential civil or criminal item. The account managers at MF Global probably left a massive paper trail in their marketing materials about how their accounts were segregated and safe, just like a regular money market account. Blatant misrepresentation would probably be fraud.

and as BR mentioned. it also applies to 401k. and SEP, and IRAs. might even apply to pensions. maybe the only things that might not have it as a ‘feature’. your checking account. and maybe the savings account. and CD

I’m not in the Trade but as a 53 year-old who now lives a couple of miles from the CME and who has a few High School friends that got very wealthy getting in to the Board of Trade /Commodites Markets circa 1977-1979, when I heard about MFG it peaked my interest. For a whole couple of days I was consumed with reading as much as I could about it.

Learning about Lease-backs, Hpothent-whatever and Rule/Reg 1.25 was truly shocking.

It’s the same M.O. as the repeal of Glass-Stegall:

Strike down — by design — and thru the power of money and influence and corporate monopolization those stop-lights/firewalls that were put in place for good reason and legalize economic terrorism.

Then the kleptocrats & the “Squid” et. al. can say, “No – Laws – were broken.”

That’s lawyer, klepto bullshit.

On any given day, all across the USA there are right-minded, parent’s punishing there children for a myriad of things that are not against the law. The result is, instilling and perpetuating the rule of law and morals in our society.

The suckholes who hide behind it not technically being illegal (after the law was “fixed” so that it was no longer and when noticed by others the making it “illegal” again was slow-walked by the so called regulaters) ought to have there asses handed to them ala that guy Sanford (?) who got a can of whoop-ass opened on him.

So far there are no criminal consequences and that points to this whole thing being just clusterfarked enough that money in a non-interest bearing “FDIC” insured account is at risk of being legally raided because of some change in the law that depositors don’t know about.

It use to be the financial sector made money helping American business and manufacturung make money via REAL productive assets. For the most part, given America doesn’t manufacture much, the Financial sector just pushes paper in convoluted schemes with no true underlying productive value.

Say Hello

About Barry Ritholtz

Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

Quote of the Day

"We don’t see things as they are, we see them as we are." -Anais Nin

Sign Up For My Newsletter

Get subscriber only insights and news delivered by Barry every two weeks.